There are two problems in the hedge fund world that Pentagon Capital Management, a London-based, multi-strategy investment manager, is seeking to solve. The first problem (or opportunity) is that in a world of 8,000 hedge funds it is increasingly difficult for start-up funds to raise enough capital to attract the attention of larger investors such as pension funds or endowments.

The second problem is that with hedge funds going to greater lengths to chase alpha it is harder to protect the downside. There is not enough excess return available to feed the vast bulk of funds, particularly after taking out their 2 and 20 compensation fees.

Pentagon Capital thinks it can deal with both problems. It has come up with a lending structure that solves the first problem and gets the protection needed to solve the second problem while making its targeted returns.

Lewis Chester took over the business from his father in the mid-1990s and took the firm from $100m in assets to a multibillion-dollar concern with more than 1,000 investors.

He believes alpha can still be found in “either very short-term, liquid trading strategies, where technology and computing capability allow for an edge, or in much longer term, illiquid trading or investment strategies, where we can get paid, through direct negotiation, for solving someone’s business or investment problems”.

In this second category are a number of “non-bank banking” transactions. One of these is lending directly to hedge funds or to their investors or managers. Pentagon refers to this financing activity as “Pentagon Finance”.

There is no single type of Pentagon Finance product and Mr Chester aims to tailor solutions to fit the problems that need solving.

These often include start-up hedge funds. He offers an example. “People from the fixed income trading desk of a big investment bank decide to leave and set up a hedge fund. They determine they need to get $20m assets under management before they can obtain external funds.

“Typically, they might consider obtaining seed equity. The quid pro quo is that they obtain the first slug of AUM in return for giving up 20 per cent – at the low end – and 50 per cent – at the high end – of their management company and/or income stream. This seed equity, therefore, might be deemed to be very expensive capital.”

Pentagon will invest the seed money into the fund, “providing the hedge fund managers have sufficient first loss capital to support the investment”.

He says: “Although we structure the finance as a loan – either through a loan note or by way of a fund derivative – the money goes into the fund as equity [that is, AUM].

“The hedge fund managers give up none of the equity and/or income stream in the business. They just pay us an interest rate on the loan amount. Better still, we can structure the loan as a month to month facility. Hence, if they want to repay, they can do so at any time.

“The question hedge fund managers have to ask themselves in this case is: ‘What is cheaper for me, debt or equity?’ If they think their business is valuable, then clearly the debt is cheaper and more flexible. If they think equity is cheaper, that tells you a lot about their business prospects, and tells prospective investors a lot, too!

“When we put together structured transactions, we obsess about aligning the interests of all parties. This type of transaction is particularly strong from this viewpoint. After all, if the hedge fund does not perform, it is the hedge fund manager who loses out first. What better comfort can there be for prospective investors than knowing that the hedge fund manager is prepared to leverage his own risk capital?

“Alternatively, in the typical seed equity model, the hedge fund manager might be deemed to have taken a free option. From an alignment of interest viewpoint, we do not like this at all. Hence, we do not like the seed equity model.”

Other types of financing for hedge funds include leveraging illiquid portfolios where banks and prime brokers will not provide any leverage.

Of course there are risks. The two principal concerns are fraud and “gapping risk” – the danger that the hedge fund drops so dramatically that it eats through Pentagon’s first loss protection. Mr Chester says this is mitigated through calculating an appropriate loan-to-value (LTV) ratio for the manager’s strategy and by ensuring the hedge fund sticks to its investment guidelines. Pentagon mitigates fraud risk in various ways, mainly by imposing institutional type controls on money flows.

Mr Chester does not believe hedge funds are over-leveraged and is concerned that they have become too conservative, “happy to rely on their annual management fee income”.

He says: “The events of 1998, in particular, coupled with the increasing sophistication of prime brokers and fund of hedge fund investors have mitigated, to some extent, the risk of over-leveraging in the industry.”

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